Macro protection for stock portfolios

Commentary: Protect your entire portfolio with one option trade

By

LawrenceG. McMillan

Columnist

MORRISTOWN, NJ (MarketWatch) -- One way to handle uncertainty in the markets is to use broad-based options to protect a portfolio of stocks. Ironically, we produced an extensive white paper on the topic of Modern Portfolio Protection in July 2007, which we tried to market to institutional investors.

Our premise was that protection was cheap, and with the market on a very non-volatile four-year run, it was time to take some defensive action for stock portfolios.

That was right near the top of the market, and -- surprise -- no one was interested in our thoughts on using options to protect their stock portfolios. Within a month, "subprime debt" had become nearly a household word, and the beginnings of what became a major bear market and financial crisis had occurred.

Now, with the market having rallied 70% off its March 2009 bottom, we are re-visiting the subject -- albeit in less detail this time.

There are several ways that an investor can hedge a large portfolio of stocks with derivatives, but there are really only two ways that make much sense. "Macro" protection means that you buy broad-based index options as a hedge to your long stock portfolio. You can thus protect your entire portfolio with just one option trade. The biggest risk in this approach is "tracking error" -- that your portfolio might not perform the same as the index does.

Sometimes, simplest is best, and that is probably the case here. There are two approaches that one could take: either buy puts on the Standard & Poor's 500 Index
SPX, +0.14%
or buy calls on the volatility index
VIX, -6.32%
Either one of those would appreciate in value if the stock market were to take another major downward hit.

In my opinion, the purchase of VIX calls is a much better, more dynamic way, to approach protection. That is because VIX will explode whenever the market declines sharply, no matter where the S&P 500 is. But if you buy SPX puts today and then a large rally ensues before a large decline occurs, the striking price of your SPX puts is likely to be so far out of the money as to do you no good during the declining phase.

We recently updated two studies regarding the cost of such protection. The first involved buying SPX puts every three months, and rolling them without fail. There was no provision for taking profits or rolling during the three-month holding period -- only at its end. The chart below shows the cost of such protective activity, assuming that the striking price of the SPX puts being bought was always initially 10% out of the money. If you think of the put purchase as an insurance policy, then the difference between the current SPX price and the striking price of the protective put can be considered your "deductible." That is how far the market will decline before your protection "engages."

As you can see, in most quarters, one lost the put premium. However, during 2000-2001 there were some substantial profits earned by the hedge. Then again, in the last quarter of 2008, there were very heavy profits earned by the SPX puts. Note that results could likely be improved by trading during the quarter -- as would have certainly been the case in July and August 2007, when the market fell sharply, but then rallied back in September. In the theoretical scenario used above, those puts were actually sold at a loss because they were held all the way to September 2007 expiration.

In the chart above6, there are about 13 years covered in the study, and the total loss was about 18% of the portfolio value. Simplistically -- without compounding -- that's an annual cost of 1.4% of net asset value to protect the portfolio with SPX puts 10% out-of-the-money. That certainly seems pretty cheap to me. This period encompasses three large bull markets and two large bear markets, so it should be fairly representative of how things might play out in the future.

Note, we also looked at buying puts with longer expirations and with other "deductibles," but the above construction seems to be better than nearly all the rest.

The other method of protection is to buy VIX calls (also out of the money). VIX options have only been trading since March 2006, so a similar study for buying VIX calls can only extend back that far.

The chart above shows the results of buying a 10% net asset value hedge using VIX calls that are out of the money, expiring each month. That is, one month calls are bought and rolled each month at VIX expiration. As an example, by "three strikes out of the money," I mean a strike that is 7.5 points above the current VIX futures price when the futures price is below 30, or a strike 15 points above the futures price when the futures price is above 30.

You can see that this hedge, using one or two strikes out of the money made a modest profit in the July-August 2007 period (referred to earlier), while the "three strikes" scenario did not. All three then made massive profits in the fourth quarter of 2008. In fact, the profits from 2008 were so great that the hedging activity has produced a gain to date for "three strikes" out of the money. One would not expect that to hold up over a longer time period (such as 13 years, as was the length of the SPX study), but this is still a more viable approach to "macro" hedging.

It should be noted that -- with either SPX or VIX -- "collars" are also viable. An SPX collar involves selling an out-of-the-money call to partly or completely cover the cost of the out-of-the-money put you are buying for protection. A VIX collar involves selling an out-of-the-money put to partly cover the cost of the VIX call you are buying for protection.

The collar strategy is far better with VIX options than with SPX options. The collar in VIX involves selling a put against the long call, and that put has limited exposure to the investor since VIX really doesn't go below 10 and obviously can't go below zero. So, one's stock portfolio would not have the "cap" on it that an SPX collared short call would impose.

In summary, there is always uncertainty in the markets. There are times when it pays to take protective activity, and this is certainly one of those times, in my opinion.

Intraday Data provided by SIX Financial Information and subject to terms of use. Historical and current end-of-day data provided by SIX Financial Information. All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only. Intraday data delayed at least 15 minutes or per exchange requirements.